In the past, private individuals and businesses currently use annuities as funding sources for insurance policies. However, the income tax ramifications as well as the lack of a system to administer such transactions on a large scale significantly limit the market for such purchases.
Individuals and charities or otherwise tax-exempt organizations have been approached with a number of systems over the years that employ the use of insurance products. There are three primary reasons that most of these systems have been unsuccessful.
First, the U.S. Internal Revenue Service has attacked many systems involving life insurance products. Tax-exempt organizations in particular must be careful not to engage in any activities that may endanger their tax-exempt status. Second, individuals and tax-exempt organizations will not generally use their existing resources to fund directly or to be used as a guarantee for the funding of such arrangements. This is because these arrangements generally do not meet their criteria for investing. Third, simplified tools necessary to administer these very complex strategies are generally not available.
There are two types of annuities relevant to this specification, deferred and immediate. Deferred annuities differ from immediate annuities in the following way. Deferred annuities “defer” payments to the investor and immediate annuities have payments to the investor that start “immediately”. Annuities were originally designed as immediate annuities because customers desired income for as long as they lived. However, as customers' interests evolved, holders of annuities desired to start their income stream at some point in the future rather than immediately, perhaps after the death of a spouse. Consequently, they put money in an annuity at present, let an insurance company invest it, and at some point in the future convert the annuity from a deferred compensation plan to an immediate compensation model. That's how the name “deferred annuity” arose because the first payment to the investor is deferred to some point in the future.
Presently, the majority of annuities that are sold are deferred annuities. The primary reason for their current popularity is that the earnings accumulate on a tax deferred basis. Thus, many customers use them strictly as a tax efficient investment vehicle. However, annuity contracts always have the right to convert it in some cases must convert at a certain age to an immediate annuity, primarily for tax reasons. Specifically, customers use annuities to defer their income tax. An immediate annuity yields an immediate income stream. Immediate is defined by the IRS as an annuity where the first payment starts within one year, i.e. within one year of the first annuity investment.
If the first payment is deferred for more than one year, it's not treated as an immediate annuity for tax reasons. It becomes similar to a deferred annuity. Most importantly, the taxation of payments, and the character of the taxation changes, with a corresponding change in the tax consequences.
Furthermore, an immediate annuity income stream can be based on life expectancy. An 81 year old has a shorter life expectancy than an 80 year old, thus enhancing the pay out, which is based on life expectancy as determined from actuarial tables. Suppose a customer gives an insurance company $100 (setting aside interest and profit). Suppose also the person had a life expectancy of ten years. The insurance company then states agrees to give that person $10 a year for the rest of their life.
Such an arrangement is, for tax purposes, characterized as a return of principal and not as taxable earnings. In an actual immediate annuity arrangement with a commercial life insurance company, the insurance company also adds interest and this interest is taxable. Also, once the principal amount has been fully returned, the entire annuity payout is taxable. Since the return of principal is completed at life expectancy, all income from the annuity after life expectancy is fully taxable. This constitutes a major increase in the tax obligation for those individuals that live past their life expectancy.
The reason the insurance company can guarantee a life income is the law of large numbers. Actuaries can tell statistically how many people are going to die before their life expectancy, and annuity companies get to keep the balance of the money. For the people that die after their life expectancy, they use the money that was saved from the early-deceased people to pay them.
Consider a person who has a five-year life expectancy. When they give the insurance company $100, the insurance company will agree to give them $20 a year for life, which looks like a 20% return guaranteed on an investment. Few other kinds of financial instruments can get a guaranteed for life 20% return on an investment, especially from an AAA rated company. Thus, the rate of return drives the concept of annuities. Another benefit is that if the purchaser lives beyond the life expectancy they win, because they get more money than what they paid. Their estate also wins if they take that income stream and peel off part of it and buy a $100 life insurance policy. This is because if they die in the first year their estate will get their $100 back from the life insurance policy.
The life expectancy of a 30 year old is much longer than an 80 year old; therefore their annuity income stream will be much smaller. Thus, the strategy described earlier would not be practical for a 30 year old because the payout of the annuity would be so low. However, an 80-year-old client can borrow money and get a high enough pay out. A qualified 80-year-old can borrow the $100 and get a high enough pay out from the annuity to pay interest on the loan, and pay the premium on a $120 life insurance policy. When he dies the lender would receive the $100 back. The $20 that's left over goes to his family.
Consequently, the lender receives money in two ways. The first is taking interest payments from the income stream paid by the immediate annuity. Second, a major life insurance company guarantees that the remaining principal will be repaid at death. The basic premise of using an annuity income stream to buy life insurance has been in the public domain for many years.